21 January 2012

The Private Equity Enigma

Much like I do with Venture Capital investments, I've often wondered how much long-term value Private Equity firms create for their portfolio companies and society as a whole.  PE shops use a combination of financial engineering and operational savvy to generate the required above market returns that their limited partner investors seek.  But do these companies that “go private” end up as better run companies?  From an Atma perspective, do they become more sustainable as a result and create lasting value for the general public?  Or is it a case of corporate raiders manufacturing gains in the short-term while leaving portfolio companies in a weak long-term position?  
Many critics (and more recently, anti-Mitt Romney candidates) have the notion of "barbarians at the gate" in which these firms layoff employees in mass, burden the companies with unsustainable debt loads, and run the company merely for quick returns.  A recent WSJ article, which examined the performance of Bain Capital portfolio companies during Romney's tenure, might support this view.  Although creating nearly 50% return for investors,  roughly 30% of the companies went bankrupt within 8 years of investment.  Further, only 10 deals (out of 77) created the lion share of the returns (4 of which subsequently went bankrupt).  Bain Capital claims the data is skewed as it generally invests in more troubled companies than most; Either way, it surprising that a firm anchored by strategic prowess had significantly more losers than winners in its portfolio. 
The truth is that it is virtually impossible to get statistically significant data to analyze whether companies are better in the long run.  So I took a different approach.  I put together some hypothetical numbers to figure out what kind of financial improvement would be necessary to generate the required rate of returns (~20-30%) for PE investors within a typical investment period (five years).  The result of my high level experiment:  financing matters more than operational improvement. 
In the heyday, firms were able to borrow almost 80% of their purchase price.  In this scenario, a nominal 5% increase in operations (annualized EBITDA growth) would yield a whopping 29% annual internal rate of return (IRR) for investors five years later. Cutting back the debt to 50% would cut the return in half.  In the same example, doubling the improvement in performance (ie. 10% EBITDA growth), would only yield a 12% incremental IRR.   Even a slight decrease in operating performance would yield positive returns. And upon exit, the company is still left with almost four-fifths of the original debt load.  
I can send anyone who wants to see my analysis, but I would have hoped that company improvement would have mattered more.   Negotiations with suppliers, closure of underperforming locations, some minor changes in operations can readily achieve a 5% lift.  And it is clear that as debt becomes harder to come by, PE returns have significantly dropped.  It is also hard to find big successes through the PE umbrella.  Even the Bain home runs like Staples have struggled post-IPO.  And even if Staples created more jobs, what about the thousands of local office supply dealers that were forced to close its doors?
The fact that leverage matters most in these deals shows that investment performance has little to do with how the companies actually do long-term.  We are in the midst of the second PE hangover in which overleveraged companies bought up by firms at the debt market peak have yet to restructure (remember Chrysler or Hilton?).   It is clear that private equity firms will have to work harder on the operational side to generate the kinds of returns their limited partners are accustomed to.  Much like governments these days, firms have to work on both cleaning up their existing debt and investing with less borrowing capacity.  So if you are looking to invest in a PE firm, you may want to look at their ability to garner debt and sell companies much more than their track record of improving company operations.  


  1. Very Interesting Raki. Send me your quantitative analysis. I would love to take a peak and get educated :)These firms almost never have a benevolent mindset behind these acquisitions. Their intentions are purely monetary, which is not necessarily a bad thing every time.

    You might agree that most of these investment firms know that their success rate is not going to be too high, they just want to hit a couple of home runs. After all, even a batter who hits .300 in his career makes it to the hall of fame.


  2. The sad state of PE affairs is that almost all firms in the industry would have below market returns were it not for the ability to deduct interest expenses. Of course, over the long term, most PE firms have trailed the broader market anyway.

    Taxpayers gave Mitt Romney his riches; very little of it had to do with making significant operational improvements in firms, but instead just levering them up with tax deductible capital while hoping things break their way.

    The worst thing that could happen to the PE industry would be to get rid of the corporate income tax, and instead tax individual capital gains and dividends at the same rate as ordinary income. It would eliminate the benefit from over-levering a company, and the only private equity firms that would be successful are those that truly created value or found undervalued assets.

  3. Agree. Tax deduction and cap gains have significantly helped among cheap money and other factors. Its too bad operational improvements are last on the list of priorities, but demand has never been higher for pe investments. Even though returns are dropping, so to are the alternative investment vehicles.

  4. I think there is an fundamental error in your analysis. Leverage effects both the expected return and the discount rate. Leverage alone will not create value except through the effect on taxes (which will not generate the returns you are discussing). See the Modigliani and Miller theorem.

  5. Agree with you on the expected rate and increased level of risk. For purposes of my analysis, I did a straight IRR % based on varying degrees of leverage (as opposed to a discounted cash flow). The bottom line is with significant debt levels, only a slight improvement can yield high IRRs for a particular investment. The point is PE firms have not really demonstrated long-term improvements in companies but are still able to manufacture financial returns for their investors.